We're Being Downgraded For The Wrong Reasons

August 6, 2011

S&P's argument contains a crucial flaw, but its ultimate conclusion is right. The American political system is much riskier and less stable than it was before.

The basic situation is that we have a political system that, in most cases, requires both parties to agree on major policy changes. One of those parties is only willing to bring revenue in line with outlay if the ideological terms of that adjustment are 100% congenial to their demands -- and even then, it is far from clear that the Republican approach would actually succeed in stabilizing the deficit. In the short term, action on a fiscal adjustment is hopeless.

Now, what about that flaw? The flaw is that the S&P seems to believe that Republican opposition to tax increases can block any fiscal adjustment indefinitely. It writes:

Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.

That is a total misread of the debt ceiling showdown. It did demonstrate Republican opposition to increasing revenue. But the crucial reality is that the Bush tax cuts expire after 2012 barring action by Congress. What's more, Republicans have signaled that they will not extend the tax cuts on income below $250,000 a year unless the tax cuts on income over that level are extended as well. As I've argued endlessly, this provides a huge opportunity to the Obama administration. It can simply refuse to extend the tax cuts for the rich, demand a clean tax cut bill for income under that level, and when Republicans refuse, blame them for hiking middle class taxes while taking quiet satisfaction as projected revenue increases by $4.6 trillion, solving the medium-term deficit problem. I can't be sure by any means that this will happen. But this is an open question, and the debt ceiling deal did not reduce the likelihood of a tax stalemate.

So the risk does not lie between now and the end of 2012, and there's a decent chance that the stalemate will actually solve the problem. However, the long-run political risk is quite severe. No other advanced country has a major political party influenced by supply-side economics and the moral teachings of Ayn Rand, and therefore, no other major political party can match the GOP's theological opposition to revenue. One result is that the Republican Party is always going to use its political power to reduce revenue, which means that the U.S. budget can never be stable for an extended period of time. If a center-left coalition succeeds in stabilizing the budget, Republicans will eventually destabilize it. It is difficult to imagine the GOP, as it's currently structured, encountering conditions in which they believe taxes are not too high.

Presidential systems of government, with the legislature and the executive often representing opposing parties, are inherently prone to crises of legitimacy. The declared Republican goal of using the debt ceiling as an instrument to extract policy concessions on a regular basis adds an explosive new element of long-term risk.

In a nutshell, when you have a political party that does not agree that revenue levels must bear a relationship to outlays, and is willing to foment a systemic crisis in order to maximize its leverage, you're in trouble.